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The assumption of product differentiation is also incompatible with the assumption of free entry, especially if the entrants are completely new firms as in Chamberlin’s model. A new firm must advertise substantially and adopt intensive selling campaigns in order to make its product known and attract customers from already established firms. Product differentiation and brand loyalty of buyers create a barrier to entry for new firms.
The concept of the industry is destroyed by the recognition of product differentiation. Each firm is an industry in its own right since its product is unique. Heterogeneous products cannot be added to give the industry demand and supply curves. Such summation would be meaningful if the price were unique for the close substitutes constituting the industry. Chamberlin’s ‘heroic model’ is clearly not acceptable as an approximation to the real world in which demands and costs are different among the various firms, giving rise to a cluster of prices rather than a unique price. Of course retention of the concept of industry in economic analysis is very desirable.
It is useful to group together close substitutes and analyze their ‘demand’ and ‘supply’ conditions. However, one should establish the relationship between the individual demand and cost curves and the market demand and supply curves. This relationship is not established by Chamberlin outside his ‘heroic model’. Although he relaxes the ‘heroic assumptions’ as untenable in the real world, Chamberlin does not examine the implications of this step for his theory. Thus the model of monopolistic competition has been criticized for vagueness of concepts and for being non-operational.
The model assumes a large number of sellers. But it does not define the actual number of firms necessary to justify the myopic disregard of competitors’ actions. How many firms should there be in an industry in order to classify it as monopolistically competitive rather than as oligopoly? What is the crucial number that determines whether firms act independently or recognize interdependence? Such problems are not discussed by Chamberlin.
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We have mentioned the difficulties in grouping firms in an ‘industry’. The model assumes that the products should be close substitutes with high price and high (positive) cross-elasticity’s. However, this requirement is vague, since it is not clear what is the precise value of elasticity’s which would be necessary for the classification of products in the same group.
The assumptions of Chamberlin from which he derived the negatively sloping curve have been attacked by Andrews. He argues that Chamberlin’s dd curve is of questionable analytical use, because it includes only the consumers’ demand, and because it implies irrationality of consumers’ preferences in the long run. Andrews argues that Chamberlin’s demand curve (and any downward-falling demand curve) is applicable only for those rare cases where a firm sells directly to the final consumer, and this only in a short-run analysis.
The dd curve ignores the demand arising from other manufacturing firms which buy the product as an intermediate commodity to submit it to further processing. It also ignores the bulk of final demand transactions which are carried out by retailers and wholesalers. These type of customers (other manufacturing firms and traders) are themselves profit maximisers and hence, the argument runs, they will not be prepared to pay a higher price for a product sold by other suppliers at a lower price.
Therefore the part of demand for the product of a firm arising from other manufacturing firms, retailers and wholesalers cannot give rise to a downward-falling demand curve. This argument is valid for all intermediate commodities, and in particular raw materials. However, for consumer goods, durable and non-durable, as well as for machinery and other equipment, brand names do actually create ‘sticky preferences’ and ‘brand loyalty’ of the buyers not only in the short run but also in the long run.
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It is observed that over long periods of time products that are close substitutes are sold at different prices. For example, soaps and detergents, fabrics, machinery, household durables are sold at a range of prices, which at least partly reflect brand loyalty of the buyers to the particular products.
The demand of final consumers for the product of the firm sold directly to them can be downward-sloping, Andrews argues, only in the short run. Only for a short period of time will the consumers be prepared to stick to a commodity whose price is higher than that of its close substitutes. Furthermore advertising can create ‘sticky preferences’ only in the short run.
In the long run the consumer will try other less expensive substitutes and, being rational, will turn permanently to them. A downward-falling demand curve in the long run can exist only if consumers are irrational. This argument of Andrews cannot be generally accepted. To begin with, the argument implies a specific definition of consumers’ rationality. A consumer would be irrational if he could identify two identical products and still would pay a higher price for one of them.
However, products are or appear different to the consumers. The consumer is rational when he maximises his utility. Clearly if by paying the higher price the consumer gets more satisfaction for various reasons (for example, satisfaction from buying from an expensive shop which is fashionable), he cannot be accused of being irrational.
The consumer may have all sorts of priorities depending on his tastes, information and time available, and he can only be judged as irrational if he exhibits purchasing patterns inconsistent with his preferences, but not on the nature of his preferences by themselves. Furthermore it is an empirical fact that products having the same (broadly) technical specifications are being sold over several years at different prices, and still they have their own market share although this share may fluctuate over time as new brands are introduced and/or old ones are discontinued. Rational or irrational, the preferences of consumers are such as to give rise to a downward-falling demand curve even in the long run.
In particular the demand for durables which involves fairly large expenditures is bound to be based on ‘good reputation’ and ‘information from friends who have tried the products’ rather than on minor price differences. It is also true for such products that the buyer may think he perceives ‘crucial’ differences between rival products – durability, aesthetic appearance, etc. Different buyers will weigh these differently, thus creating their brand loyalties.
Only when prices differ considerably would one expect a switch of custom from well-established to new products. In summary, it is an observed fact that for long periods firms producing close substitutes have kept some market share for their individual products despite price differentials. Whether one defines the situation as implying rationality or irrationality on the part of the consumers is irrelevant for the pricing decisions of firms.
It has been argued that Chamberlin’s model is indeterminate, due to the effects of product changes and selling activities. Those factors create interdependence of the demand and cost curves of the firm, rendering the equilibrium indeterminate. This argument is not valid. The fact that the cost and demand curves have some common determinants does not necessarily mean that the equilibrium is indeterminate. So long as each of these functions has particular determinants not influencing the other, the demand-and-supply model is identifiable and has a unique solution.
Despite the above criticisms Chamberlin’s contribution to the theory of pricing is indisputable.
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The most important of these contributions is the introduction of product differentiation and of selling strategy as two additional policy variables in the decision-making process of the firm. These factors are the basis of non-price competition which is the typical form of competition in the real world.
Another contribution is the development of a model which provided a solution, certainly not the only possible or the best, but still a solution, to the dilemma of the falling costs.
The explicit discussion and incorporation of selling activities into price theory is an extremely important step forward in the explanation of the phenomena of the business world. The U-shaped selling-cost curve assumed by Chamberlin may be questioned on theoretical and empirical grounds, but his is the earliest systematic attempt to make an analysis of the selling activities and their influence on the position and shape of the demand of the individual firm.
Another contribution is the introduction of the share-of-the-market-demand curve as a tool of analysis. The combination of dd and DD gave rise to the ‘kinked-demand’ curve which has been widely used subsequently as a possible explanation of oligopolistic behaviour.
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Finally, Chamberlin’s attempt to preserve the ‘industry’ in price theory is important. His assumptions were, as he himself was aware, ‘heroic’ and unrealistic, but his analysis shows the need for a comprehensive theory of price which will explain the behaviour of the individual firm within an industrial framework. Chamberlin’s subsequent abandonment of the ‘group’ after its heavy criticism by Triffin and others has been rather a drawback in the development of the theory of the firm.